About Microcredit

Microcredit is used to describe small loans granted to low income individuals that are excluded from the traditional banking system. It is part of the larger microfinance industry, which provides not only credit, but also savings, insurance, and other basic financial services to the poor. The term ‘micro’ stems from the relatively small amounts of money that are being borrowed or saved.

A Brief History Of Micro-finance

The Beginnings

Micro-finance has existed in various forms for centuries, and even longer in Asia, where informal lending and borrowing stretches back for several thousand years. However, the birth of ‘modern’ micro-finance is said to have occurred in the mid 1970s in rural Bangladesh. There, in the midst of a famine, Dr. Muhammad Yunus, professor of economics at the University of Chittagong, was becoming disillusioned with the abstract theories of economics that failed to explain why so many poor people were starving in Bangladesh.

A 27 Dollar Loan

Determined to find a practical solution, Yunus began visiting local villages. In one nearby village, Jorba, he found a group of 42 women who made bamboo stools. Because they lacked the funds to purchase the raw materials themselves, they were tied into a cycle of debt with local traders, who would lend them the money for the materials on the agreement that they would sell the stools at a price barely higher than the raw materials.

Yunus was shocked to find that the entire borrowing needs of the 42 women amounted to the equivalent of US$27. He lent them the money from his own pocket at zero interest, enabling the women to sell their stools for a reasonable price and break out of the cycle of debt.

The Grameen Bank

The Grameen Bank project, which translates literally as “Village Bank”, was born, and today works in over eighty-thousand villages with more than six million borrowers. In 2006 both Yunus and Grameen were awarded the Nobel Peace Prize for their work with the poor.

Rapid Growth

Inspired by the success of The Grameen Bank, the 1970s and 80s saw rapid growth in the number of new micro-finance institutions appearing around the world, many of them started by NGOs and funded by grants and subsidies from public and private sources. They demonstrated that the poor could be relied on to repay their loans, even without collateral, and hence that micro-finance was a potentially viable business.

A New Model

During the 1990s, the industry began to realise that it could not continue to grow at such rates while still relying on grant funding. As a result, many began to restructure themselves to attract commercial investors, adopting more formal business practices and working to improve their efficiency and sustainability.

The Formation of Positive Planet

1998 saw the formation of Positive Planet (ex Planet Finance), a not-for-profit organisation whose initial objective was to use the internet and new communication technologies to reinforce the capacities of NGOs in various sectors. This soon evolved into the Positive Planet that we know today; an international NGO whose mission is to fight against poverty by developing micro-finance.

The Entrance Of Major Players

As enthusiasm for micro-finance as a tool for poverty alleviation increased, focus moved away from NGO models towards promoting a sustainable industry that could provide financial services to the poor at fair prices while offering a reasonable return to commercial investors. As well as the many micro-finance investment firms that exist today, several large banking institutions have also entered the industry, such as Credit Suisse, Deutsche Bank and Citigroup.

By the end of 2008, nearly $15 billion of foreign investment had been channelled into micro-finance institutions, the majority still from government development organisations such as the World Bank, but with large amounts arriving from a variety of private and commercial sources.

Recent Innovations

In recent years micro-finance has been the subject of various innovations and experiments, from leveraging the hugely popular mobile banking industry, where mobile phones are used to send and receive money, for the purpose of micro-finance; to the introduction of new loan products tailored to local contexts, such as machinery loans, harvest stock spaces, and cattle fattening loans.

Loan methodologies have also diversified, and the original model of supportive group loans pioneered by the Grameen Bank, which have become more complex and adapted to local realities. Currently, products such as micro-insurance and micro-savings, which previously took the back-seat to micro-credit, are seeing their popularity increase.

Towards The Future

The future of micro-finance is hard to forecast, but several estimates suggest that 500 million to 1,5 billion people still lack access to financial services that could strengthen their economic situation and improve their life conditions.

Additionally, 2.5 billion young people will become adults within the next ten to twenty years, and it seems uncertain whether the traditional working market will be able to absorb such demographic boom. The role of micro-finance and other alternatives ways to encourage and assist auto-entrepreneurship are likely to remain important in the global economy.

Micro-Entrepreneur

Informal businesses are the basis of economic life in the developing world. Markets in the centre of town are the main distribution centres, similar to supermarkets in the developed world, while street vendors take the place of our local shops and stores. Production of goods is usually local and artisanal, rather than large-scale industrialised. Part of the reason for this small geographic spread of activities is the lack of good transport infrastructure, lack of public transport, and relative high cost of private transportation.

A micro-entrepreneur is an individual who either runs, or works in, the small businesses that constitute the informal sector of the economy. These businesses can be in a variety of sectors and industries, ranging from agriculture, farming, or fishing, to transportation, small shops or stalls, food production, or artisans. The structure of these micro-businesses may be individual, familial or collective. Some individuals may be entrepreneurs by choice, while others have become entrepreneurs through necessity due to a lack of employment opportunities. Levels of poverty can also differ from person to person, from the vulnerable non-poor to the very poor.

While micro-entrepreneurs are a very diverse group, they have one thing in common: they are unable to access financial services through formal routes, such as traditional banks, because they do not meet the requirements that many of these institutions set, such as minimum deposits, collateral, a steady income, or a proven credit record.

Today, more than 150 million people worldwide, served by more than 10,000 Micro-finance Institutions (savings and credit cooperatives, NGOs, micro-finance banks…) and commercial banks, benefit directly or indirectly from micro-finance activities. It is estimated that over 500 million entrepreneurs remain excluded from financial services.

Microfinance Institutions (MFIs)

Micro-finance Institutions (MFIs) are the organizations that offer micro-finance services and products to the poor. There are many different types: savings and credit cooperatives, NGOs, programmes established by international organisations, legally-recognized micro-finance institutions, and micro-finance banks, and their sizes greatly vary, from 100 clients to over 6 million clients for the largest. As well as offering basic financial services such as loan products, savings accounts, and insurance, many MFIs also provide non-financial services such as training and education, or specific programmes to combat local issues.

The types of micro-finance institutions vary almost as widely as the types of micro-finance clients they take on. Originally an industry dominated by grant-funded NGOs and charities, micro-finance institutions have become increasingly sophisticated and now attract investment from major commercial banks. To find out more about a specific MFI, please visit mixmarket.org

Microcredit Interest Rates

Micro-finance is based upon the notion of moving away from traditional aid towards a sustainable and viable industry; therefore interest charges are necessary to cover the costs of administering the loans. The interest rates charged by micro-finance institutions are often considerably higher than those offered by traditional financial institutions. This is because the cost of administering many small loans in rural areas is much higher than the cost of administering fewer large loans in developed urban surroundings.

In addition to normal operational costs, the interest rates must be able to cover:

The cost of funding to the MFI – of ten higher in developing countries, as foreign funders will require a higher return to cover the additional risk of lending to micro-finance institutions.

Exchange rate risk – of ten higher in developing countries; currencies may be volatile, illiquid, and inflation may be high.

Risk of borrower default – higher as borrowers can rarely offer collateral or credit history.

Administrative costs – compare the cost to your bank if you make a transaction at a branch or via the internet, versus the cost to an MFI of sending a loan officer weekly or monthly to collect repayments from a client in a rural village without a proper transport infrastructure. The latter is also likely to be a much smaller sum of money, making the transaction cost per euro or dollar much higher for the MFI.

This does not mean that all high interest rates are justifiable. It is important that MFIs are efficient and work to reduce their operating costs; this is something that the industry carefully scrutinises, and as the level of competition between MFIs grows, so does the pressure on them to reduce their rates.

So how are micro-entrepreneurs able to afford these interest rates? Several studies have been conducted in Mexico, India, Kenya and the Philippines, which have shown that the percentage return on investment is much higher for micro-enterprises than larger businesses, finding rates ranging from 117% up to 847%1,2.

In fact, Richard Rosenberg, senior advisor at the Consultative Group to Assist the Poor (CGAP), has suggested that there is overwhelming empirical evidence that huge numbers of micro-businesses are able to pay interest rates that would usually strangle larger businesses because the interest charge only makes up a small proportion of the input costs of the micro-business3, a view that is supported by research by Schmidt and Kropp (1987)4.

Involvement of Others

Modern micro-finance has experienced rapid expansion and evolution, from its humble beginnings a few decades ago, to an instrumental tool in the fight against poverty. These changes would not have been made possible without the involvement of others within the industry.

Financial backers

Financial backers act as a catalyst, helping new MFIs or micro-finance projects to initiate and grow their activities through grants or investment. The aim is usually for the institution to eventually become self-sustained, but this often takes years of investment before it becomes a reality. Financial backers are often either public institutions such as the World Bank, the European Commission, or private foundations and funders, such as Citigroup, Blue Orchard or Oikocredit.

P2P Micro-credit Websites

One of the latest innovations in micro-credit financing is the introduction of the general public through peer-to-peer micro-lending. Several websites have been launched in the past few years that use the power of the internet to enable the general public to support micro-entrepreneurs through loans.

Governments

Governments can determine the rate of growth of the micro-finance industry within their country through the regulations they enforce. Many regulations designed for the banking industry may not be appropriate for the micro-finance industry, and therefore can be restrictive unless sector-specific regulations are introduced. Governments often also provide financing to the micro-finance sector within their country, something which can be both positive and may also harm the industry, for example by discouraging private-sector delivery of services.

Rating Agencies

Rating Agencies such as MicroRate analyse and report on the financial, organizational and social viability of MFIs. They contribute actively to improving the transparency of the sector, and enable potential funders to easily assess the risk of a particular MFI.